Iron Ore's Other Problem

I've long chronicled iron ore's plight, stemming both from a slowdown in Chinese demand and continued increased supply.

China's iron ore demand slowdown stems mostly from a slowdown in its residential construction boom. This slowdown was politically promoted even if it would inevitably collide with insufficient demand at some point.

The continued increased supply of iron ore, namely the attempt to supply more low-cost iron ore, is a direct consequence of the very high returns available in the iron ore market, which up until recently meant all the large suppliers had ROE's in the 30s.

The dynamics of this situation naturally produced a significant reduction in iron ore pricing, which up until recently had been under what was termed "scarcity pricing" by BHP Billiton's (NYSE:BHP) Alberto Calderon. From prices in the $160s per ton one year ago, we're down to $119 per ton now and that's already up significantly from the lows below $90 made in early September.

These dynamics alone leave a lot of room for debate. At the center of this debate is China's steel intensity, which is pictured below (source: Rio Tinto Chartbook 2012).

Click to enlarge

This kind of chart clearly leaves the impression that albeit China is consuming a lot of steel per capita, it can clearly consume even more, thus lending credence to the expected strong increase in iron ore demand over time.

But there's a problem

Beyond the fact that there seem to be short term problems with demand and a continued expected increased supply in iron ore, there is another problem. This is a problem which the expected Chinese steel consumption increase does not capture.

You see, iron ore is not the only basic material which can be used to make steel. Steel itself, in the form of scrap, can also be used to make new steel. And indeed, it's usually cheaper, requires less investment, less energy and produces less pollution, to produce steel from scrap. It's thus not a surprise that as of 2010, 37.5% of the world's crude steel was made from scrap. And in developed markets, such as the U.S., this share went as high as 60% (source:" World Steel Recycling in Figures 2006 - 2010", Bureau of International Recycling).

Herein lies the problem. In China, the share of scrap was just 14%. Indeed, since China is close to 50% of the world's steel production, China's scrap usage strongly reduces the world average. This means that over time, it's likely that a lot more than 37.5% of the world's steel will be produced from scrap. It also means that China's usage of scrap is set to go higher. A lot higher.

Naturally, as China tries to make more usage of scrap, this usage will increasingly substitute iron ore (though through different production processes). For instance, if Chun Chi Wai, chairman of China Metal Recycling Holdings is to be believed, by 2015 one could expect 20% of China's steel to be made from scrap versus 14% today. This alone would be huge, it could for instance account for 7.5% higher steel production without any increase in iron ore demand. Given that iron ore producers by and large continue to invest in increased production capacity, stagnation of demand would have serious negative consequences for iron ore pricing.

Conclusion

Even beyond the debate about iron ore's demand and supply, another problem emerges for iron ore producers. China is presently using little scrap in its steel production and everything points towards that not lasting. The end result is that even if China's steel production expands, this might not translate into higher iron ore demand, with the consequence being lower iron ore prices.

At this point, I expect iron ore to stabilize below $100/ton in the short term (it's $119/ton right now), and over the longer term (2014 onwards), I expect iron ore to stabilize below $75/ton.

These dynamics can be negative for the main iron ore producers, BHP Billiton, Rio Tinto (NYSE:RIO) and VALE (NYSE:VALE). But they're especially dangerous for those producers which carry high leverage or operate at higher costs, such as Australia's Fortescue or Cliffs Natural Resources (NYSE:CLF). The market is presently distracted by the pricing recovery which took place in the last few weeks, but these longer term dynamics are highly likely to re-assert themselves.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.